Chapter 10 End of Chapter 10 ECON 151 – PRINCIPLES OF MACROECONOMICS

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1 Chapter 10End of Chapter 10ECON 151 – PRINCIPLES OF MACROECONOMICSChapter 11: Classical and Keynesian Macro AnalysesMaterials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.1

2 The Classical ModelThe classical model was the first attempt to explainDeterminants of the price levelNational levels of real GDPEmploymentConsumptionSavingInvestment

3 The Classical Model (cont'd)Classical economists—Adam Smith, J.B. Say, David Ricardo, John Stuart Mill, Thomas Malthus, A.C. Pigou, and others—wrote from the 1770s to the 1930s.They assumed wages and prices were flexible, and that competitive markets existed throughout the economy.

4 The Classical Model (cont'd)Say’s LawA dictum of economist J.B. Say that supply creates its own demandProducing goods and services generates the means and the willingness to purchase other goods and services.Supply creates its own demand; hence it follows that desired expenditures will equal actual expenditures.

6 The Classical Model (cont'd)Assumptions of the classical modelPure competition exists.Wages and prices are flexible.People are motivated by self-interest.People cannot be fooled by money illusion.

7 The Classical Model (cont'd)Money IllusionReacting to changes in money prices rather than relative pricesIf a worker whose wages double when the price level also doubles thinks he or she is better off, that worker is suffering from money illusion.

8 The Classical Model (cont'd)Consequences of the assumptionsIf the role of government in the economy is minimal,If pure competition prevails, and all prices and wages are flexible,If people are self-interested, and do not experience money illusion,Then problems in the macroeconomy will be temporary and the market will correct itself.

9 The Classical Model (cont'd)Equilibrium in the credit marketWhen income is saved, it is not reflected in product demand.It is a type of leakage from the circular flow of income and output, because saving withdraws funds from the income stream.

10 The Classical Model (cont'd)Equilibrium in the credit marketClassical economists contended each dollar saved would be matched by business investment.Leakages would thus equal injections.At equilibrium, the price of credit—the interest rate—ensures that the amount of credit demanded equals the amount supplied.

12 Equating Desired Saving and Investment in the Classical ModelSummaryChanges in saving and investment create a surplus or shortage in the short run.In the long run, this is offset by changes in the interest rate.This interest rate adjustment returns the market to equilibrium where S = I.

13 The Classical Model (cont'd)QuestionWould unemployment be a problem in the classical model?AnswerNo, classical economists assumed wages would always adjust to the full employment level.

16 Figure 11-4 Classical Theory and Increases in Aggregate DemandClassical theorists believed that Say’s law, flexible interest rates, prices, and wages would always lead to full employment at real GDP of $12 trillion

17 Figure 11-5 Effect of a Decrease in Aggregate Demand in the Classical Model

18 Keynesian Economics and the Keynesian Short-Run Aggregate Supply CurveThe classical economists’ world was one of fully utilized resources.In the 1930s, Europe and the United States entered a period of economic decline that could not be explained by the classical modelJohn Maynard Keynes developed an explanation that has become known as the Keynesian model.

19 Keynes and his followers arguedKeynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd)Keynes and his followers arguedPrices, including wages (the price of labor) are inflexible, or “sticky”, downwardAn increase in aggregate demand, AD, will not raise the price levelA decrease in AD will not cause firms to lower the price level

21 Figure 11-6 Demand-Determined Equilibrium Real GDP at Less Than Full EmploymentKeynes assumed prices will not fall when aggregate demand falls

22 Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd)Real GDP and the price level, 1934–1940Keynes argued that in a depressed economy, increased aggregate spending can increase output without raising prices.Data showing the U.S. recovery from the Great Depression seem to bear this out.In such circumstances, real GDP is demand driven.

25 Example: Bringing Keynesian Short-Run Aggregate Supply Back to LifeNew Keynesians contend the SRAS curve is essentially flat.Based on research, they contend SRAS is horizontal because firms adjust their prices about once a year.The underlying assumption of the simplified Keynesian model is that the relevant range of the short-run aggregate supply schedule (SRAS) is horizontal.

26 The price level has drifted upward in recent decades. Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run (cont'd)The price level has drifted upward in recent decades.Prices are not totally sticky.Modern Keynesian analysis recognizes some—but not complete—price adjustment takes place in the short run.

27 Short-Run Aggregate Supply CurveOutput Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run (cont'd)Short-Run Aggregate Supply CurveRelationship between total planned economywide production and the price level in the short run, all other things held constantIf prices adjust incompletely in the short run, the curve is positively sloped.

29 Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run (cont'd)In modern Keynesian short run, when the price level rises partially, real GDP can be expanded beyond the level consistent with its long-run growth path.

30 Output Determination Using Aggregate Demand and Aggregate Supply: Fixed versus Changing Price Levels in the Short Run (cont'd)All these adjustments cause real GDP to rise as the price level increasesFirms use workers more intensively, (getting workers to work harder)Existing capital equipment used more intensively, (use machines longer)If wage rates held constant, a higher price level leads to increased profits, which leads to lower unemployment as firms hire more

31 Shifts in the Aggregate Supply CurveJust as non-price-level factors can cause a shift in the aggregate demand curve, there are non-price-level factors that can cause a shift in the aggregate supply curve.Shifts in both the short- and long-run aggregate supplyShifts in SRAS only

36 Consequences of Changes in Aggregate DemandRecessionary GapThe gap that exists whenever equilibrium real GDP per year is less than full-employment real GDP as shown by the position of the LRAS curveInflationary GapThe gap that exists whenever equilibrium real GDP per year is greater than full-employment real GDP as shown by the position of the LRAS curve

37 Figure The Short-Run Effects of Stable Aggregate Supply and a Decrease in Aggregate Demand: The Recessionary Gap

38 Figure The Effects of Stable Aggregate Supply with an Increase in Aggregate Demand: The Inflationary Gap

39 Explaining Short-Run Variations in InflationIn a growing economy, the explanation for persistent inflation is that aggregate demand rises over time at a faster pace than the full-employment level of real GDP.Short-run variations in inflation, however, can arise as a result of both demand and supply factors.

43 Aggregate Demand and Supply in an Open EconomyThe open economy is one of the reasons why aggregate demand slopes downward.When the domestic price level rises, U.S. residents want to buy cheaper-priced foreign goods.The opposite occurs when the U.S. domestic price level falls.

44 Aggregate Demand and Supply in an Open Economy (cont'd)Currently, the foreign sector of the U.S. economy constitutes over 14% of all economic activities.

45 Figure 11-14 The Two Effects of a Weaker Dollar, Panel (a)Decrease in the value of the dollar raises the cost of imported inputs.SRAS decreases.With AD constant, the price level rises.GDP decreases.

46 Figure 11-14 The Two Effects of a Weaker Dollar, Panel (b)Decrease in the value of the dollar makes net exports rise.AD increases.With SRAS constant, the price level rises with GDP.

47 Chapter 10End of Chapter 10ECON 151 – PRINCIPLES OF MACROECONOMICSChapter 11: Classical and Keynesian Macro AnalysesMaterials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.47